The Federal Unemployment Tax Act (FUTA) is a payroll tax paid by employers. The tax rate is 6% on the first $7,000 of taxable wages for each employee, each year. The IRS requires employers to contribute to the federal unemployment pool to cover employees who qualify for unemployment benefits. Employers are subject to FUTA tax if they meet at least one of two conditions:

The IRS offers a FUTA tax credit of 5.4% that may be claimed on the annual 940 tax return. Employers qualify for the tax credit if they have paid their state unemployment taxes on time. Since most employers make payments on time, especially if they use a payroll provider, the FUTA tax rate used during the year is the reduced rate of .6%. In other words, those who run payroll assume that the company qualifies for the rate of .6% (as opposed to 6%) and automatically apply it.

When states are unable to pay unemployment benefits, they may borrow from the federal government to facilitate those payments. If the state does not repay the loan within two years, the federal government is entitled to recover the unpaid loan from the state by reducing the amount of the FUTA tax credit. This means that until the loan is repaid, every company with employees in that state pays more in FUTA taxes.

The credit reduction is .3% for the first year (after the two-year grace period) that the loan isn’t repaid. For each year the loan is not repaid, the credit reduces another .3%. Once the loan is paid in the full, the state is eligible for the full tax credit. To illustrate, let’s look at what happens during the first three years a loan isn’t paid back. The first year the loan isn’t repaid, the 5.4% tax credit drops to 5.1%. The next year it drops to 4.8%, and the next it drops to 4.5%. This pattern continues until the state repays the federal government. Note that it’s extremely rare for the credit to reduce more than .3%. With the amount of unemployment caused by the COVID-19 pandemic, it could potentially happen in the near future; however, it’s generally not something that you’ll need to worry about.

Because payroll providers assume that the 5.4% tax credit applies, they only deduct .6% for FUTA taxes throughout the year. Therefore, if your state is subject to a tax credit reduction, then by the end of the year you’ll owe money to the IRS.

Calculating the tax credit reduction is pretty straightforward. Simply take each employee’s FUTA taxable wages (up to $7,000) for the calendar year and multiply by .3%. (FUTA Taxable Wages) x (.003) = Amount Owed This means the maximum additional tax per employee is $21.

Each year the IRS will announce which states are subject to the tax credit reduction. In 2023, the following states are subject:

If you have employees in multiple states, the credit reduction only applies to the states listed above. It is calculated based on the employee wages paid to the state for unemployment tax. For example, if an employer pays unemployment to California, Idaho, Nevada and Utah during 2023, the tax credit reduction is only applied to the employee wages paid in California—because that’s the only state on the list above.

Still have questions? The IRS and US Department of Labor each provide in-depth information about the FUTA tax credit and the credit reduction. Here are some resources to start with if you’re interested in diving deeper: